Floating-Rate Note (FRN)

A Floating-Rate Note (FRN), often called a “floater,” is a type of bond or debt instrument whose interest payment is not fixed for its entire life. Instead, the interest rate it pays fluctuates periodically based on an underlying benchmark reference rate. Think of it as a chameleon of the bond world, adapting its colors (its payout) to the surrounding economic climate. Unlike a conventional fixed-rate bond that pays the same coupon amount year after year, a floater’s coupon is reset at regular intervals, such as every three or six months. This reset mechanism is the FRN's superpower, designed to protect investors from one of the biggest boogeymen in the bond market: rising interest rates. Because the coupon payment rises in lockstep with market rates, the price of the FRN itself tends to remain very stable, making it a popular choice for conservative investors looking to preserve their capital.

The magic of a floater lies in its simple but effective formula. The interest payment, or coupon, an investor receives is calculated by taking a widely recognized benchmark rate and adding a fixed extra margin, known as the spread. Coupon Rate = Benchmark Rate + Spread Let's break that down:

• The Benchmark Rate: This is a variable, independent interest rate that reflects the current cost of borrowing in the financial system. For notes denominated in U.S. dollars, a common benchmark is the Secured Overnight Financing Rate (SOFR). For euro-denominated notes, it's often the Euro Interbank Offered Rate (EURIBOR). This part of the formula is what “floats.”
• The Spread: This is a fixed percentage added on top of the benchmark rate. The spread does not change over the life of the bond. It is determined when the FRN is first issued and primarily reflects the creditworthiness of the issuer. A financially sound government or blue-chip company will pay a smaller spread than a riskier, less-established company. The spread is the investor's compensation for taking on the issuer's credit risk.

For example, imagine you own an FRN that resets its rate every three months. The formula might be “3-month SOFR + 1.00%”. If the 3-month SOFR is currently 4.50%, your note would pay an annualized rate of 5.50% (4.50% + 1.00%) for the next three months. If, at the next reset date, SOFR has risen to 5.00%, your coupon will automatically adjust upwards to 6.00%.

Investors aren't just drawn to FRNs for their clever mechanics; they choose them for very practical, portfolio-protecting reasons.

This is the number one reason to own an FRN. When central banks like the Federal Reserve or the European Central Bank raise rates to fight inflation, owners of traditional fixed-rate bonds watch in horror as the market value of their holdings falls. Why? Because newly issued bonds now offer higher yields, making the old, lower-paying bonds less attractive. This phenomenon is called interest rate risk. Floaters almost completely sidestep this problem. Since their coupon payments automatically adjust upwards with the prevailing rates, they remain just as attractive as new issues. As a result, their market price tends to hover very close to their face value (par value), exhibiting very low volatility. This stability makes them a safe haven when interest rate uncertainty is high.

For investors who rely on their portfolio for income, FRNs offer a stream of payments that keeps pace with the cost of money. While the income isn't perfectly predictable like that from a fixed-rate bond, it is reliable and adjusts to the current economic reality. This can be preferable to being locked into a low, fixed-yield when inflation is eroding your purchasing power.

While FRNs are relatively safe, they are not risk-free. It's crucial to understand the potential downsides before investing.

This is the risk that the company or government that issued the bond will be unable to make its interest payments or repay the principal at maturity. This risk is present in all corporate and municipal bonds, floaters included. If the issuer's financial health deteriorates, the market value of its FRN will fall, regardless of what interest rates are doing. Always check an issuer's credit rating before buying.

The feature that makes FRNs so attractive when rates are rising becomes their main weakness when rates are falling. If the benchmark rate drops, so will your coupon payments. An investor who bought an FRN expecting a 5% return could see their income shrink to 3% or less if the central bank starts cutting rates. This is the trade-off for protecting yourself against rising rates.

Some FRNs come with special conditions that limit the interest rate's movement. You must check the bond's prospectus for these features.

• A Cap: This is a maximum interest rate the note will ever pay. A cap limits your potential profit if rates skyrocket, which is good for the issuer but bad for you.
• A Floor: This is a minimum interest rate the note will ever pay. A floor protects your income from falling below a certain level, which is good for you but bad for the issuer.
• A Collar: This is a bond that has both a cap and a floor, creating a “collar” or range within which the interest rate can float.

For a value investing practitioner, FRNs are not a tool for generating spectacular wealth like undervalued stocks. Instead, they are a strategic instrument for capital preservation and risk management within the fixed-income portion of a portfolio. A value investor sees FRNs as a sensible place to park cash, especially during periods of monetary tightening or high inflation. They allow an investor to earn a reasonable return—one that adjusts to inflation—without taking on the significant interest rate risk of longer-term bonds. The primary focus for a value investor would be on minimizing credit risk by selecting FRNs from highly creditworthy issuers. They are a tool of prudence, allowing you to keep your “dry powder” safe and productive while you wait for compelling opportunities to appear in the stock market.